FX Math: Fed Handcuffed By Fiscal Policy

The Federal Reserve is being held hostage by the gridlock in Washington.

With the acrimony over budgets and spending limits reaching a fever pitch over the past week, it’s highly unlikely that the Fed will decide to start cutting back on its stimulus when it meets again at the end of the month. The madness in Washington is threatening the health of the economy, and the Fed knows that announcing a reduction in its so-called quantitative-easing program would further destabilize a fragile recovery.

But the problem runs deeper than that. Even when the current stalemate is resolved, the debt ceiling is raised and the budget negotiations are completed, the winding down of the Fed stimulus program threatens to undermine whatever deal is struck.

It’s a severe enough problem that I don’t see how the Fed can end its stimulus program by the middle of 2014, the timetable that Fed Chairman Ben Bernanke gave in June. And I’m skeptical that there will be anything more than a nominal cut in stimulus efforts in early 2014.

Such an extended timetable hasn’t been priced in by the currency markets–yet. When it is, the result will be a much weaker dollar than many are expecting for the next six months, and perhaps longer.

The problem, as outlined by David Kotok of Cumberland Advisors in a commentary he emailed to clients last week, has to do with the knock-on effects that will be felt in the federal budget when the stimulus is gone.

When investors thought in early September that the Fed was poised to taper its bond-buying, the yield on 10-year Treasuries shot to 3%. Given that earlier move, it’s entirely conceivable that interest rates will reach 4% when the Fed finally does turn off the spigot and economic growth starts to goose inflation a bit. Such an increase will increase the amount the federal government pays to service its debts–possibly by hundreds of billions each year. I think we could see a 4% level by the end of next year, though Mr. Kotok imagines a longer time frame.

But that’s only part of the problem. Over the longer term, the Fed will need to rid itself of the $85 billion in bonds its gobbling up each month as part of its stimulus effort. Currently, the trillions of dollars in bonds that the Fed has purchased throw off about $100 billion in interest annually–money that the Fed turns around and hands right back to the Treasury. That helps reduce the deficit, but it won’t last forever.

The combination of the two factors amounts to a subsidy that, if ended now, would equal a 10% levy on the current $3.8 trillion budget, a resulting drag on fiscal spending that no one in Washington is talking about as they bloviate about what needs to happen to break the current impasse.

For currency traders, this amounts to a mess. When the easing of the stimulus finally arrives, a less accommodative Fed is a positive for the dollar. But in the long term, a higher U.S. debt-to-GDP ratio and larger deficits are a drag on the economy and bad for the U.S. currency.

To trade on this over the next several days, weeks and months, I propose shorting the dollar to go long the euro, on the assumption that the Fed will keep the stimulus party going for longer than most people think.

The technical indicators suggest Europe’s single currency is poised to go much higher, with the Elliott Wave pattern indicating a retreat to $1.3445 before the next wave in the cycle sends the currency to $1.3904. Elliott Waves are supposed to show that crowd psychology fluctuates from an optimistic to a pessimistic view of a market, and I can see a shift in sentiment pushing the euro to $1.4193 depending on the depth of Washington’s turmoil.

In addition, the Ichimoku cloud, a method of illustrating trading and pricing trends, also suggests that momentum will lift the euro higher.

Investors across the globe have spent the last several months enjoying the sugar rush of stimulus that’s boosted markets and padded portfolios. The U.S. government has been quietly nursing a sweet tooth, too. They’ll both get to enjoy the party for a bit longer, but the aftermath is going to be brutal.

(Vincent Cignarella is a currency strategist/columnist and co-inventor of The Wall Street Journal Dollar Index, with 30 years experience in currency markets including as a bank dealer at major money-center commercial banks. He can be reached at vincent.cignarella@dowjones.com.)